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Debt funds are not risk-free. Tread carefully

LiveMint logoLiveMint 25-04-2017 Monika Halan

Are you thinking of investing in a debt fund? If data is any indicator, you may be already there because the assets under management of debt-oriented funds held by non-HNI (high net-worth individuals) retail investors have jumped by just over 40%, as on 31 March 2017, over the previous year to reach around Rs67,000 crore. As bank deposit interest rates fall, investors begin to look for better return options. This has coincided with rising awareness about the efficiency of the mutual fund vehicle to offer a full basket of products for instant to very long-term needs. Along with the awareness have come products and fintech solutions that now allow instant access to some parts of your money. Once on-boarded and linked to an online platform or app, mutual fund investing is a breeze.

But many investors believe that equity is risky and debt is safe. You’d be right in making this judgment call if the ‘debt’ was a bank fixed deposit (FD) or a government-guaranteed bond. But debt mutual funds carry risk.

Remember, when you lend money, the interest is the reward you get for postponing your consumption, to take care of the effects of inflation on the money you get back and for the risk of the borrower not returning your money. The government is considered to have no risk of default and therefore the rate at which the government borrows is called the risk-free rate. As the credit-worthiness of firms falls, the interest they offer rises. When you invest in a debt fund, the scheme goes out and buys bonds and other fixed return instruments. The risk in debt funds comes from several sources. I will discuss the three most important aspects for this conversation.

The first is interest rate changes, or an interest rate risk. This is the risk of your fund manager’s interest rate call going wrong. We know that bond prices rise when interest rates fall. If your fund manager expected rates to fall and managed his portfolio (I am deliberately not using jargon here, but for those interested do look up ‘duration’) accordingly, but rates went up, your investment will compare unfavourably with others who took the right interest rate call.

The second is the risk of default by the borrower—or a credit risk. Funds are allowed to invest in debt papers that are rated investment grade by credit ratings agencies. But within this band of investment grade, it is possible for fund houses to invest in lower-rated papers than the safest paper in the market. When things go wrong for the firm that borrowed money from the mutual fund, the credit ratings can drop sharply and the value of the fund suffers. When such an event happens and there is a big redemption pressure, the third risk kicks in: lack of liquidity—or the lack of a market when you want to exit. The non-government Indian bond market is not very liquid, that is, fund managers may not find buyers if they need to sell in distress.

Unlike equity, debt fund risks are much more difficult for the retail investors to understand. Not just investors, even mutual fund agents and advisers may not correctly understand all the risks or have the ability to analyse portfolios. Some of them have pushed the concept that debt funds are safe and equity is risky. Debt fund investors have chased higher returns believing that debt funds are ‘safe’. As funds have flowed into schemes that performed better than others in their category, mutual funds have increasingly begun to take credit risk, that is, buy paper that is investment grade but lower rated by credit rating agencies. Remember that less creditworthy firms need to offer higher interest to borrow in the market.

When the mutual fund buys lower rated paper—or less creditworthy paper—it increases the risk on your investment. Fund houses have come up with innovative names to indicate the higher risk such as ‘credit opportunities funds’. But the retail investor understands ‘opportunity’ not as risk but as a good opportunity to earn better returns, forgetting that higher returns come with higher risk.

There have been three instances in the debt fund market in the past few years when the credit risk came to bite investors. Fund houses have either allowed the investors to take the hit in price or have ‘managed’ to sell the paper to group companies and avoided the drop in price. The correct way is for the fund houses to pass on the fall in value to the investors because a mutual fund is not an assured return product and investors must understand risks. But given that product labelling is poor in debt funds and investors (and many agents and advisers) are largely unaware of the risks they take when they buy a debt fund, the taking-on of the price hit on its own books can be justified at this stage of the market. But this is not an ideal state if we want more investors to come in. The market risk should belong to the investor finally.

This needs regulatory action to streamline, define and label debt funds so that they are true to label. (Disclosure: I’m on a Sebi sub-committee debating some of these issues presently).

Today a debt fund investor needs to match her holding period to that of the underlying portfolio of the fund, needs to check the credit quality of the portfolios held by each scheme, needs to check if the portfolio is too concentrated. This is too big an ask. Not just for investors but for most of the sellers of the funds as well. Sebi will have to find a way to ring-fence and label funds where the market risk is minimal (I say minimal but not zero because there will always be a big global or national event that will freeze any market and even bank deposits become frozen in such cases) so that conservative investors find it safe to on-board debt funds.

Sebi also needs a system to label funds with their correct names, put in metrics of risk that take note of the various risks in the scheme and allow a retail investor to match investing horizon and risk appetite to the scheme she buys. Mutual funds are poised for exponential growth ahead. Continual reform and streamlining will prevent market failures.

Monika Halan works in the area of consumer protection in finance. She is consulting editor Mint, consultant NIPFP, and on the board of FPSB India.

She can be reached at monika.h@livemint.com

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